335: The Power of the 1031 Exchange – Part 1

SHOW NOTES FOR EPISODE 335: THE POWER OF THE 1031 EXCHANGE – PART 1

The dynamic capital-gains-deferring 1031 Exchange is perhaps the most misunderstood, yet powerful, wealth-building tool for all real estate investors.  Yet few investors really understand the scope and benefits of this invaluable tool.  In this first episode of a two-part podcast series, author, journalist, attorney, accountant and real estate investor Michael Lantrip digs deep into the Section 1031 IRS ruling to share it’s power, value and ultimately what it means to you.

What You Will Learn

• The true definition of a 1031 Exchange or, as it is also called, a Section 1031
• Why the term “Exchange” is misleading
• What happens with the deferred capital gains taxes when the owner of a 1031 Exchange property dies
• The 10 “unwritten” rules governing a 1031 exchange that every investor using a 1031 exchange needs to know
• How you can get in the “Zero Capital Gains Tax Bracket” to never worry about paying capital gains tax
• Ways to strategically soften up or work around the 45-day exchange transaction limit

About Our Guest

Michael Lantrip

Michael Lantrip, Attorney at Law, is licensed to practice in Texas, North Carolina, Virginia, and the District of Columbia. He is also admitted to practice in the U.S. Tax Court, the U.S. Federal District Court, Eastern District of Texas, and the D.C. Court of Appeals.  He has a B.B.A. in Finance from the University of Houston School of Business, and he has a Juris Doctor (J.D.) in Law from the University of Texas School of Law.  He practices in the fields of Tax Law, Real Estate Law, Corporate and Business Law, and Wills, Trusts and Estates.  As a Criminal Defense Attorney, he has taken three cases to the Texas Court of Criminal Appeals, winning two of them.  As a County Attorney, he handled almost 2,000 misdemeanor criminal cases.  Formerly a Tax Examiner for the IRS, and a Tax Accountant for a Big 8 Accounting Firm, he has also been a Newspaper Reporter, Radio Announcer, Radio News Director, Television Reporter and Anchorman, Television Executive News Producer, and Military Intelligence Analyst.  In addition to 35 years of practicing law, he built one of the first computerized Abstracts Plants and operated his own Title Insurance Company, and has been an Approved Title Attorney for seven national Title Insurance Underwriters.  He has handled over 2,000 real estate closings.  As a Real Estate Investor, his activities have ranged from Travel Trailers to Office Buildings, and from on-campus Condos to hundreds of acres of land.

Prior to his law career, he was a Radio Announcer at WQTE in Detroit during the “Motown” era, and he was a DJ at KIKK in Houston when it was named “Country Music Station of the Year” by Billboard Magazine.  He has written over 700 stories as a daily Newspaper Reporter, he has written and produced more than 1,000 half-hour Television Newscasts, has logged over 8,000 hours on the radio, was named a Top Writer 2018 by Quora.com, and is a Lifetime Member of Mensa.

More About Michael

• He has had 7-8 professions
• He is not primarily a real estate investor but many of his clients are investors – he does the legal, tax and accounting and is part of many investors’ teams
• His divesting from his real restate investments because he is moving from Texas to the North Carolina, Virginia, and D.C. area
• From the Piney Woods of East Texas
• He enjoys the real estate side of things
• Not interest in retiring
• His next book will be entitled “10 Other Real Estate Investments You Can Do” and will focus on things like
  • Hard money lending
  • Used mobile homes
  • Raw land development
  • Storage units
  • Billboards
  • Section 121 real estate investing – where a person can sell the residence they are living in for 2 out of the prior 5 years and pay no taxes on the profit
  • And more

1031 Exchange Defined

• “No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.”
  • What that means is “you sell your property, use all of the net sales proceeds from that sale to buy another property and there’s no capital sales tax to be paid.”
  • The gain is deferred, it’s rolled into the property that you buy.  And it’s there. It doesn’t incur interest, there’s no penalty.  It’s just there until you sell that second property.  And you can do another 1031 exchange when you sell the second property and you can delay it forever.

What Happens to a 1031 Property if the Owner Dies?

• What happens if the property owner dies?
  • It goes to a “stepped-up basis”
    • For your heirs who inherit the property, they don’t have your “basis” in the property, which you may have purchased at $100,000 and trade it up through 1031the property is assessed at “fair market value” – not the initial amount you paid for the first property
      • So, if the property’s fair market value is $1,000,000 and they sell the property within a 6 month period, then they have NO CAPITAL GAINS because their basis is the $1,000,000 – that was the basis of the fair market value of the property on the date of death, when they inherited it. That $1,000,000 is without capital gains.

The Term “Exchange” Better Defined

• The IRS will simply make up words and hope everyone accepts their definition of the terms
• A 1031 Exchange doesn’t real mean you “exchange” one property for another.  It really means you are “replacing” one investment property with another investment property.
• It doesn’t mean you are “trading” one property with another
• It really means that you are selling one property and buying another in place of the previous property
• Also the term “like kind,” used in the IRS definition, doesn’t mean “physically like” – it means the same type of “business or investment” property
• Personal property (for example, art collections, airplanes, farm equipment, etc.) used to be included in the 1031 Exchange definition (prior to 2018), but no longer is that the case.  They changed the work “property” to the term “real property”
• If you sold an apartment building and used the money to buy a business franchise that would like be allowable but Michael would not recommend that

The 10 “Unwritten” Rules for a 1031 Exchange

• There are no specific “written rules” for the section 1031 outside of the definition
• There are, however, rules that have just “come along,” have been promulgated from the statute, Revenue rulings, private letter rulings and so forth — just been created like moxie
• The rules are generally easy to understand.  They are definite rules — there are no exceptions
• Here are ten of those rules:
  1. Both properties must be business or investment properties
  2. Replacement Property (the one that you sell) price must be equal to, or greater than, the sales price of the Relinquished Property (the property that you buy)
  3. All of your Net Sales Proceeds from the sale of your Relinquished Property must be used in the purchase of your Replacement Property. (If the replacement property is of less value, you will have to pay capital gains tax on the difference and you would also have to pay depreciation recapture taxes)
  4. The name that goes on the deed when you receive title to the Replacement Property must be the same name that was on the deed that transferred title of the Relinquished Property
     1. The exception would be if you go from your personal name into a “disregarded entity” single member LLC (file IRS form 8842)
        1. If you have a single member LLC, you can set it up to be taxed as a disregarded entity, meaning that all the income and expenses for that property can run through your personal income taxes
        2. If you don’t file form 8842, it will default to your personal taxes
     2. Another option is to form an LLC and chose to be taxed as a Sub-S corporation
     3. Or, you could chose to be taxed as a C-corp
  5. The date that you sell the Relinquished Property (the date escrow closes) is called the Exchange Date, and you have 45 days to identify in writing to your Qualified Intermediary (QI), the person you’ve designated to handle funds in the transaction,  a list of the possible (3) properties that you will consider for purchase as your Replacement Property.  You have three choices of how to do this.
     1. You can identify up to 3 properties without regard to the value of each and without regard to the total value of all three together.
     2. You can identify as many properties as you want, as long as the total value of all of the properties is not more than 200% of the value of the Relinquished Property.
     3. You can identify as many properties as you want without regard to value, as long as you end up closing on enough of the properties to represent 95% of the total value of all of them.

 Other Options:

• 1. 1. You can change the properties on a list anytime or as often as you want within the 45 days
     2. You can also build in some flexibility on the due date by negotiating with Replacement Properties before you sell your Relinquished Property and making the sale date of the Relinquished Property any date you want, depending on the purchase date of the Replacement Property

(The list of ten “unwritten rules” will continue in Part 2)

Other Important Tax Tips

• You should ALWAYS buy a Relinquished property at the same amount or more than the amount you sold your Replacement property for or the tax consequences could be severe
• You can actually be in “zero capital gains tax bracket” (having a modified adjusted gross income of $78,000 or less and filing jointly)  and be able to sell your properties and never have to pay capital gains taxes

THIS CONCLUDES PART-ONE OF OUR PODCAST SERIES ENTITLED “THE POWER OF THE 1031 EXCHANGE.”  STAY TUNED FOR THE EXCITING CONCLUSION ON MONDAY, AUGUST 19th

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